China’s one-year interest-rate swap rose by the most in 22 months as the central bank refrained from adding funds to the financial system to ease a cash squeeze, causing demand to fall at a government debt auction.

“The cash shortage may get even worse before the quarter-end because banks will have to hoard cash to meet loan-to-deposit ratio requirements,” said Chen Qi, a strategist at UBS Securities Co. in Shanghai. “The central bank probably won’t come out to intervene unless there is a sharp decline in economic growth and large capital outflows.”

“The market is disappointed by the lack of reverse repos from the PBOC,” said Frances Cheung, a strategist at Credit Agricole CIB in Hong Kong. “The liquidity squeeze stems from less inflows and policy makers’ own policy to crack down on shadow banking, so the PBOC may be reluctant to use short-term tools to help.”

Fitch Ratings said in a statement yesterday that the cash shortage reflects the move to reduce shadow banking, a measure that will ultimately slow economic growth.

Capital Flight

The statement by Chen Qi “The central bank probably won’t come out to intervene unless there is a sharp decline in economic growth and large capital outflows” is interesting.

A front-page editorial on Friday in China Securities Journal - an arm of the regulatory authorities - warned that capital inflows have slowed sharply and may have begun to reverse as investors grow wary of emerging markets. “China will face large-scale capital outflows if there is an exit from quantitative easing and the dollar strengthens.” it wrote.

The journal said foreign exodus from Chinese equity funds were the highest since early 2008 in the week up to June 5, and the withdrawal Hong Kong funds were the most in a decade.

It also warned that total credit in Chinese financial system may have reached 221pc of GDP, jumping almost eightfold over the last decade. Companies will have to fork out $1 trillion in interest payments alone this year. “Chinese corporate debt burdens are much higher than those of other economies and much of the liquidity is being used to repay debt and not to finance output,” it said.

There have been signs of serious stress in China’s interbank lending markets, with short-term SHIBOR rates spiking violently. Bank Everbright missed an interbank payment last week in a technical default.

“Liquidity conditions have tightened severely due to the crackdown on shadow banking activities,” said Zhiwei Zhang from Nomura.

China's shadow banking system is out of control and under mounting stress as borrowers struggle to roll over short-term debts, Fitch Ratings has warned.

"The credit-driven growth model is clearly falling apart. This could feed into a massive over-capacity problem, and potentially into a Japanese-style deflation," said Charlene Chu, the agency's senior director in Beijing.

"There is no transparency in the shadow banking system, and systemic risk is rising. We have no idea who the borrowers are, who the lenders are, and what the quality of assets is, and this undermines signalling," she told The Daily Telegraph.

Bank Everbright defaulted on an interbank loan 10 days ago amid wild spikes in short-term "Shibor" borrowing rates, a sign that liquidity has suddenly dried up. "Typically stress starts in the periphery and moves to the core, and that is what we are already seeing with defaults in trust products," she said.

Fitch warned that wealth products worth $2 trillion of lending are in reality a "hidden second balance sheet" for banks, allowing them to circumvent loan curbs and dodge efforts by regulators to halt the excesses.

This niche is the epicentre of risk. Half the loans must be rolled over every three months, and another 25pc in less than six months. This has echoes of Northern Rock, Lehman Brothers and others that came to grief in the West on short-term liabilities when the wholesale capital markets froze.

Overall credit has jumped from $9 trillion to $23 trillion since the Lehman crisis. "They have replicated the entire US commercial banking system in five years," she said.

The China Securities Journal said total credit in China's financial system may be as high as 221pc of GDP, jumping almost eightfold over the last decade, and warned that companies will have to fork out $1 trillion in interest payments alone this year. "Chinese corporate debt burdens are much higher than those of other economies. Much of the liquidity is being used to repay debt and not to finance output," it said.

Shadow Banking Crackdown

This shadow banking crackdown is a good thing. The longer it is put off the more violent the reaction when it does happen.

Yet, the crackdown was put off so long already, severe ramifications on growth are already baked in the cake.